We will soon be into budgeting season for many companies. For sales executives this is high stress as they will already now have some feeling for order intake next year, and whether they will fail or bring back some impressive bonus checks. In practice though, sales target setting is in most organizations an automatic process based on fairly established company policies developed over many years and ingrained in the company culture. Still, some companies consistently go for high targets (specifically with target higher than unbiased estimate of next-year’s order intake), others for low targets. It is then of interest to understand why this is, and why there is no single optimal target policy.
Of course, some differences may be explained by cultural attributes; for example, in some companies they may want all reasonably good sales people to bring in some bonus every year, in others they may use bonus arrangements to get rid of the dead meat amongst sales staff, again on an annual basis. Some differences may also be explained by organizational level; for example the order intake (= sales) budget at CEO level may be set consistent with the revenue budget and so that the CEO is expected to deliver on the budget every year, while the targets for sales staff may be set significantly higher, to create a bit of stretch and temperature in the organization.
Also, some bonus schemes are pretty linear, and some are highly non-linear. We will in the following restrict ourselves to highly non-linear bonus schemes with a lower cut-off, typically 70-80% of target for a sales executive (meaning no bonus and possibly notice of dismissal for levels lower than 70-80%), 90% for an EVP Sales, and 95-100% for other top management (sometimes meaning sacking of the CEO if not on budget or higher). However, these percentages are just half of the equation, the effective failure target achievement FTA (= cut-off / unbiased estimate) is then the combined percentage of (cut-off / target) (from employment contracts) and (target / unbiased estimate) (from company policy, adjusted annually). The (target / unbiased estimate) ratio is typically set to 130% in an aggressive sales organization, and to 95-97,5% for top management in larger technology organizations, meaning a typical FTA of 91-104% for a software sales executive, 117% for an EVP Sales, and 90-97,5% for a CEO.
It could of course be argued that sales target setting is driven by optimizing on the effort the sales staff put in: high targets will result in more hours worked, and therefore more order intake, but too high targets will result in disillusionment, exhaustion, loss of morale, and loss of good talent.
However, if one assumes that sales executives will for any target level work on those deals that will minimize the probability of failure, and if one does the math, one will see that sales target setting is really about managing the degree of risk averseness or risk-seeking in the organization. In the figure below, I have plotted probability of failure as function of # opportunities worked on, for a given FTA:
(I have in the above figure assumed that sales effort is simply a constant percentage of deal size, total sales effort is fixed, win probability is same for all opportunities, and there is a large pool of un-pursued opportunities of varying size. These assumptions may be lifted, without such adjustment adding very much to the discussion. Note that I have also compared exact calculations using the ‘correct’ binomial distribution with discrete outcomes (the ragged lines), with approximate calculations using continuous normal distribution with continuous outcomes (the dashed lines).)
Note that the unbiased estimate of order intake is same in all FTA scenarios, just the deal mix and the resulting variability around mean are different. What we see is that if setting high targets, rational sales executives will go for a few large deals, with significant risk to the company, but some, but low probability of success. What we also see is that if setting low targets, rational sales executives will go for many small deals, with small risk to the company.
The combined outcome of the effect of target on effort, and the effect of target on risk results in two typical cases: Case I: low FTAs, many small deals, risk-averseness, predictable sales performance, low attrition of personnel, and reasonable # hours worked per week; or Case II: high FTAs, a few large deals, risk-seeking, highly variable sales performance, high attrition of personnel, and insane # hours.
The above is consistent with what we observe in reality: inside organizations, across organizations within same industry, and across industries. Examples of case I are farmer roles, after sales roles, COOs, CEOs, and technical software. Examples of case II are hunter roles, EVPs of Sales, corporate finance, M&A professionals, and top-tier strategy firms.
Key takeaways from this study are:
- Accept that sales executives are rational individuals with a good grasp of simple math and will gravitate towards many smaller deals and risk avoidance if you set targets on the low side; towards few, large deals and risk-seeking if you set targets on the high side.
- If your company’s success depends on having a well-oiled sales engine that consistently generates order intake, set targets on the low side. If your company’s success depends on a couple of large, mega-deals, set targets high.
- Manage the risk that target setting may create incentives for sales staff that may be inconsistent with your company’s best interest. Example: when approaching year-end, a desperate sales executive may want to pursue the low-probability mega-deal to just creep over FTA, while the company may want him or her to pursue a larger number of smaller high-probability deals within his or her territory.
- Do not think that setting an arbitrarily high target will necessarily increase probability of budget achievement; it may not, and for two reasons: i) disillusionment, exhaustion, loss of morale, and loss of talent; and ii) increased risk-taking.
- In general, ensure good alignment between that target setting policy, organizational objectives (incl. target attrition rate), and company culture.